Accounting profits provide an intermediate view of the viability of your business. Although one year of losses may not permanently harm your business, consecutive years of losses or net income insufficient to cover living expenditures may jeopardize the viability of your business. Opportunity costs relate to your money net worth , your labor and your management ability.
If you were not farming, you would have your money invested elsewhere and be employed in a different career. Opportunity cost is the investment returns given up by not having your money invested elsewhere and wages given up by not working elsewhere. These are deduced, along with ordinary business expenses, in calculating economic profit. Economic profits provide a long-term perspective of your business. If you can consistently generate a higher level of personal income by using your money and labor elsewhere, you may want to examine whether you want to continue farming.
People often mistakenly believe that a profitable business will not encounter cash flow problems. Although closely related, profitability and cash flow are different. An income statement lists income and expenses while the cash flow statement lists cash inflows and cash outflows. An income statement shows profitability while a cash flow statement shows liquidity.
Many income items are also cash inflows. The sale of crops and livestock are usually both income and cash inflows. The timing is also usually the same cash method of accounting as long as a check is received and deposited in your account at the time of the sale. Many expense items are also cash outflow items. The purchase of livestock feed is both an expense and a cash outflow item.
The timing is also the same cash method of accounting if a check is written at the time of purchase. However, there are many cash items that are not income and expense items, and vice versa. For example, the purchase of a tractor is a cash outflow if you pay cash at the time of purchase as shown in the example in Table 2. If money is borrowed for the purchase using a term loan, the down payment is a cash outflow at the time of purchase and the annual principal and interest payments are cash outflows each year as shown in Table 3.
The tractor is a capital asset and has a life of more than one year. It is included as an expense item in an income statement by the amount it declines in value due to wear and obsolescence. The depreciation expense is listed every year. Depreciation calculated for income tax purposes can be used. However, to accurately calculate net income, a more realistic depreciation amount should be used to approximate the actual decline in the value of the machine during the year. In Table 3, where the purchase is financed, the amount of interest paid on the loan is included as an expense, along with depreciation, because interest is the cost of borrowing money.
However, the principal payments are not an expense but merely a cash transfer between you and your lender. An income statement is only one of several financial statements that can be used to measure the financial strength of a business. Other common statements include the balance sheet or net worth statement and the cash flow statement, although there are several other statements that may be included.
By doing a profitability analysis, companies can identify areas in need of attention. There are 3 key analyses that you can do to help determine profitability. Each of them provides a different view of your situation.
Your gross profit margin is the amount of your sales revenue minus the cost of your goods. In conjunction with your other numbers, your gross profit margin can tell you if your products are profitable enough, if you need to increase sales or if your expenses, like sales costs, are too high.
A little more complicated than your Gross Profit Margin, the Net Profit Margin is sometimes simply called the profit margin. To get this number, subtract your expenses from your revenues to get your net profit. Then divide that by your revenue.
This will give you a 10, foot view of your overall profitability. Few businesses have only one product or service. You can calculate this either by taking the revenue for the segments and subtracting the associated costs or can include a portion of overhead costs — like rent, utilities, salaries, etc.
Download our Forecasting Toolkit to learn how intelligent forecasting increases efficiency for your business. Your profit margin might look weak to you, but is it? Different industries have different levels of profitability. Real estate, health care, and financial services tend to have high profit margins. Other industries, like autos, and grocery, have margins that are much lower.
Benchmark your industry before looking at your profitability so you know what to aim for. Your customers are the source of your revenue — and your profits. But how much are they really worth?
Are you spending like crazy to acquire new customers? Are your service customers better at producing profits than your products? If your company is profitable you may want to know how much breathing room you have should revenues take a dip. If your company is losing money, knowing the break-even point will tell you how far you are from beginning to turn a profit. In addition to evaluating your present situation you can, and should, also use break-even analysis for profit planning.
We will show you how to calculate a break-even point both for sales and for units sold. Before we do that, however, let's quickly review the concepts of fixed and variable expenses. Expenses that are defined as "fixed" do not vary with sales. They are the day-to-day expenses that your business will incur regardless of how sales volume is increasing or decreasing. Some examples of fixed expenses include overhead, administrative costs, rent, salaries, office expenses, and depreciation.
Variable expenses, on the other hand, do vary with sales. Let's say your company makes paper clips by cutting and bending pieces of wire. As you sell more paper clips, you have to buy more wire. The expense for wire varies with your sales. Typical variable expenses include the cost of goods sold as shown on the income statement and variable labor costs like overtime wages or salaries for sales personnel.
Variable expenses will increase and decrease according to sales volume. Make the best guess you can to divide expenses into the categories of fixed and variable.
There are no hard and fast rules for the allocations; it is up to you and your knowledge of the business. Once you have the three pieces of information — fixed expenses, variable expenses, and sales — you can use the information in conjunction with the following formula for calculating your company's break-even point.
Until sales reach the break-even point no profits can be recorded, but the next sales dollar will contribute to profits. Now, let's calculate the level sales must reach to achieve break-even. To do it, we will find what percentage current variable expenses are of total sales.
Here is how the owners of the Doobie Company would calculate the break-even point for their business, using data taken from the income statement above. Their first step is to separate fixed costs from variable costs. The Doobie Company's only variable cost is the cost of goods sold. Selling, general, and administrative expenses are all fixed costs. For your company, the data may not break out so evenly. Just divide fixed and variable costs to the best of your ability.
Variable expense for the Doobie Company is the cost of goods sold as a percentage of sales. As you may remember from algebra class, it becomes a negative. So now we have, on one side of the equation, 1S minus. The next dollar of sales will include some profit. Calculate the sales break-even point for your business. Using Break-Even Analysis for Profit Planning Now that we understand how to calculate the break-even point, we can make one small adjustment to the break-even analysis formula so we can do some "what if" planning about profitability.
After all, you don't want to just know where you are today in terms of break-even. You almost certainly also want to know how to attain a given amount of profit. You can easily calculate the amount of sales necessary for a desired amount of net income before taxes. Use break-even analysis to calculate a specified amount of net income for your business. Break-Even Analysis for Units Sold Depending on what kind of business you are in, it is may be useful for you to calculate break-even in terms of the number of units sold as well by revenues.
In other words, you want to know the number of units that must be sold to reach the break-even point. For the Doobie Company, the variable expense was. If it sells only 5,, it is not yet generating any profits. On the 5,d unit it sells, part of the revenue from the sale of that unit will contribute to profits. If appropriate for your business, calculate the number of units that must be sold to reach the break-even point.
You compute it using data from both the income statement and the balance sheet. This ratio is useful when you compare the figure for the most recent period with results from earlier periods in your company's history.
It can also be very informative when you compare your company's return on assets with the returns generated by other businesses in your industry. If your company's return on assets ratio is lower than those of other companies, this may indicate that your competitors have found ways to operate more efficiently.
If your company's current return on assets is lower than it was a year ago, you should look at what has changed in the way your company is using its resources. Return on Investment Return on investment is considered by many executives to be the most important profitability ratio.
It measures the return on the owner's investment or owners', if there are more than one. For you as a small business owner, the return on investment figure can help you decide whether all of your hard work has been worth it.
If the return you are receiving on the money invested in your company does not at least equal the return you would receive from a risk-free investment such as a bank CD , this could be a red flag. Calculate the return on assets and return on investment for your company. Compare them to at least one source of compiled financial ratios as noted in the Resources section below. How do your ratios compare to others in your industry?
Used alone or in combination, they can give a small business owner a good picture of the financial viability of his or her business. As a management tool, objective profitability measures such as the ones shown here are invaluable tools for financial management. They are also important to the small business owner because these common profitability measures will be used by outsiders, such as bank loan officers, investors, and, even, merger and acquisition specialists, to evaluate the management skill and potential for success of a company.
Profitability Ratios Has your gross profit margin been stable over the last few periods? If not, why?
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